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Diligence is an Issue at All Levels

By May 31, 2023No Comments

Recently the Wall Street Journal’s Saturday “The Numbers” column was about the “M-Score.” The M-Score was created by business professors in the 1990s and the M stands for manipulation. As per the Journal, it “Uses a company’s financial statements to determine whether it is engaging in manipulation.” Some of its eight ratios used to determine the score are:

  • When accounts receivable jump (for no apparent reason).
  • There are higher values on assets that can’t be sold and not identified as plant, property, or equipment.
  • A change in accruals.
  • A change in how depreciation is taken.

The M-Score’s most famous moment was when it predicted shenanigans at Enron three years before Enron’s collapse. The point of this article was they are seeing signs of this now and it may be the forewarning of a recession. Of course, a few weeks later the Journal had a column titled, “Recession Might Be Coming – But Not Just Yet.”

I’m more interested in the fraud angle as it goes to show there must be diligence on all investments, all sellers, and all buyers. First, let’s be clear, in the buying and selling of lower middle market businesses there is very little fraud. What most diligence finds are opportunities, sloppy accounting, and lack of systems. Thus, most buying mistakes are errors of omission.

Let’s start with the most ignored part of any deal, diligence on the buyer. There isn’t as much that can be done on the buyer but here’s a starter list:

  • Relationship – the seller’s gut feel for the person (or the team if it’s an institutional buyer like private equity, a larger firm, etc.).
  • A background check.
  • Getting a credit report.
  • Proof of funds and proof of financing.
  • If it’s private equity or similar, talking to the owners who previously sold to them.

Where most diligence effort and cost is directed is on the business and the seller. If you’re reading this as an owner/seller, pay attention as the following is where your buyer and their team will be picking apart your business, just to make sure it is what you’ve said it is.

  • It starts the same way, relationship. No buyer (or seller) should do a deal with someone they don’t trust. If your gut says something’s off, run. There will always be another business (or another buyer).
  • The next stop is the financial systems and statements. This is where the most effort is placed. It can range from looking at the QuickBooks file to what is known as a Quality of Earnings Report, i.e., a mini audit packaged very nicely. As my friend Brian Quint said after selling Aqua Quip to a private equity firm, be prepared for a financial colonoscopy.
  • Whether there’s a bank or not, get an IRS form 4506. This allows the IRS to provide a copy of the tax return as filed. FYI, in all my years I’ve only heard of (not seen) two times when a banker told me the IRS provided returns didn’t match what the owner gave them.
  • What’s the status of the management team and key employees? Are they aware of the deal? When will they be brought in? When can the buyer talk to them? At some point the owner/seller needs to bring in the top people because the people are really what the buyer is buying. Rarely is there an issue because the buyer wants employees to stay, the seller wants their employees jobs protected, and the employees don’t want to lose their jobs.
  • But the big one is customers. This is where most of the effort should be placed (but often isn’t). First thought on this, if a seller tells the buyer they can’t talk to the (B2B) customers (blindly, say as a reference check to use the services) it’s time for the buyer to leave. No matter what the story, run, don’t walk away. In all my 25 years in M&A I’ve only worked on a handful of deals that went bad. Here are three of them and all were because the buyer fell for the line, “You can’t talk to the customers as it’s too sensitive.”
    • Dick found the perfect match for what he wanted. The right industry and size. The relationship seemed great, he closed the deal, but didn’t talk to customers. Within months he found out the top customer was leaving. To make matters worse (and this is where the lawyers enter), an employee told him that the day he first visited the business the paper the seller ripped off the bulletin board was a letter from the client saying the relationship was ending.
    • Sean was in a similar situation, great fit, right size, and a supposedly fantastic relationship with the sellers (husband and wife). We got to the final stages of diligence, asked to speak to the customers (blindly), and were rebuffed. I told Sean to put the deal on hold. The attorney told him to kill the deal. He told us he understood why the sellers felt this way and trusted them. He soon found out that during our diligence the top customer (over 20%) was running a “test kitchen” of all the competitors’ products and didn’t invite their current supplier to participate. They hated them for nickel and diming over the years of the contract.
    • Jeremy’s situation was like Sean’s. Same excuse, same result. The sellers had a letter ending the top customers relationship that came in within 30 days of closing and was withheld from the buyer.

All the above were what I call self-inflicted wounds because the injuries could have been prevented. And let’s face it, there are some things a buyer can’t find out, like a seller lying about their future role. A client looked the owner of the company buying her business and me in the eye and said she planned to stay for at least three years. She wanted to sell, not run a business. She left after two months.

Let’s finish with a different perspective. Warren Buffett was in a feature WSJ article in the spring of 2023. He said his lawyers are always pressing him to do more diligence (that they would do). He said he’s never been burned by his level of diligence and things like a bad lease or ineffective manager can be overcome.

He emphasized his only real mistakes in due diligence were missing the mark on the economic future of the business or industry. In some cases they passed on deals only to see the industry and company skyrocket and did some deals where hockey stick growth was never going to happen.


A lesson for buyers and sellers of smaller business is the buyer must do thorough diligence on the company after determining growth is achievable. Sellers, this means be prepared for an in-depth exam of your company and be able to emphatically state how you would grow the business. I like to ask owners/sellers, if you were 20 years younger, in growth mode, what would you do to scale the business (like all buyers want to do)?